By Matt Tucker
Now that the fear of widespread municipal bond (muni) defaults has started to subside, we’re beginning to field fewer questions on that debate and more inquiries about the case for munis in today’s environment. In a recent outlook, Russ Koesterich talked about how municipal bonds have been trading at yields above their historical average, and this has continued to be the case.
What makes municipal bonds interesting to many investors, of course, is the tax benefit they can provide. An investor who buys a US Treasury in a taxable account will have to pay federal income tax on the investment, generally 28-35%. A municipal bond, on the other hand, is exempt from Federal income tax, and can be exempt from state tax if the investor lives in the state in which the muni was issued (go here for federal and state tax consequences of owning municipal bonds). This means that, all else being equal, one would expect muni bonds to yield less than Treasuries, so that they have a similar after-tax yield.
Let’s look at where the two markets are today. Municipal Market Advisors publishes an index comprised of AAA muni bonds. From 2000 to 2007 the yield on the MMA index averaged 3.20%, while 5 year Treasuries averaged 3.97% – a difference of 0.77%. For an investor in the 28% tax bracket, the average Treasury yield was 2.86% after-tax. In other words, muni bonds offered a bit more after-tax yield than Treasuries, which makes sense given the difference in credit risk.
Today the two yields are almost equal: the 5 year MMA AAA index yields 0.64% while the 5 year Treasury yields 0.68%. This is largely a hangover from the muni credit concerns that bubbled up in late 2010 and carried into 2011.
So what does an investor do if they want to invest in the muni bond market? Historically, many investors have purchased individual municipal securities directly. The challenge with that, of course, is opaque transaction costs (a concept I highlighted in a video last month). When you go to buy a bond, you can generally see the price at which you can buy it, but not the price at which you can sell it. Investinginbonds.com has a wealth of data that shows where individual bond trades have been executed. When you dig through the numbers, you find that many investors pay 1% or more in transaction costs when purchasing a bond.
Which brings us to ETFs. The muni market represents one of the clearest examples of why ETFs are increasingly being used by investors. The iShares S&P National AMT-Free Municipal Bond Fund (MUB) currently trades at a bid/offer of 0.05%, versus 1% or more for individual bonds. And not only can it be more cost effective to access the muni market through an ETF, but an investor can actually see the value of their investment on the exchange throughout the day. They can see where other investors are valuing it, and where they can sell it or even buy more of it. Individual muni bonds just don’t offer that same level of price transparency or control. And of course we haven’t even gotten into the diversification benefits of owning a muni fund. Lower transaction costs and exposure to over 1,000 bonds? That’s value add.
Disclaimer: Past performance does not guarantee future results. Diversification may not protect against market risk. Buying and selling shares of iShares Funds will result in brokerage commissions.
When comparing bonds and iShares Funds, it should be remembered that management fees associated with fund investments, like iShares Funds, are not borne by investors in individual bonds.
Bonds and bond funds will decrease in value as interest rates rise. A portion of the Fund’s income may be subject to federal or state income taxes or the alternative minimum tax. Capital gains, if any, are subject to capital gains tax.